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Real Estate Purchase Agreement with Gift Equity

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Real Estate Purchase Agreement with Gift Equity Powered By Docstoc
					Family-Controlled LLCs and
Partnerships – How Can the
  Business Lawyer Avoid
 Estate and Gift Tax Traps?
              Steven B. Gorin
           Thompson Coburn LLP
               St. Louis, MO

               Sharon L. Klein
    Fiduciary Trust Company International
                New York, NY
                    Overview
     Analyzing business issues in the family
      context, including transferring wealth to
      the next generation
     Drafting buy/sell agreements; planning to
      avoid estate tax traps caused by common
      buy-sell techniques
     Profits interests: great for income tax and
      incentive planning, but watch out for gift
      and estate tax
2
             Business Issues in
              Family Context
     Fair vs. equal
     Insiders vs. outsiders
     Solutions




3
                Fair vs. Equal
     Equal values perceived as fair
     Value creation by parents
     Value creation by children




4
           Insiders vs. Outsiders
     Outsiders want distributions
     Who controls insiders’ compensation?
     Who benefits from insiders’ creation of
     value?




5
       Solution – Benefit Outsiders
     Bequeath other assets (allocation of equal
      shares)
     Life insurance
     Separate real estate from business
      operations




6
    Solution – Buy-Out Outsiders
     Cross purchase vs. redemption
      (business issues)
     Life insurance vs. promissory note
      (business issues)
     Promissory note vs. preferred equity




7
     Solution – Control Insiders
     Tax distributions to avoid K-1 K-0
     Limit insiders’ compensation
     Give outsiders a put right




8
    Solutions – Fair to Insiders?
     Freedom to operate business
     Incentives for creating value
     Source of well-paying job
     Need separation from outsiders




9
      Shifting Value to Insiders
              During Life
      Business opportunities; loans
      Leveraged transfers
      Discount planning
      Financial security to parents to
      encourage above



10
      Business Opportunities –
        Business Expansion
      New operating entity owned by
       insiders
      New real estate entity owned by
       outsiders or combination
      Financed by parents



11
                          Gift    Trust(s) for
            Parents
                                    Insiders


Loan or loan guarantee            Small equity investment

                      New Operating
                        Business




12
                            Gift
                                       Trusts for Outsiders
             Parents
                                         (and Insiders?)


loan or loan guarantee                 small equity investment

                         New Real
                         Estate LLC

                                   lease payments

                         Operating
                         Business


 Note: Can use for existing or new operating business
13
 Business Opportunities – Loans
  At or above applicable federal rate (AFR)
  Credit risk ignored but need intent to repay
  Loan guarantee controversy
  Back-to-back loans




14
              loan                  loan
     Bank               Parents                 Entity
             security              security
             interest              interest



            Note: Loan from parents to entity
             should be at or above AFR but
                 may be below market




15
        Leveraged Transfers

      Sale to irrevocable grantor trust
      Grantor retained annuity trust




16
             Sale to Irrevocable
               Grantor Trust
 What is an irrevocable grantor trust?
      Irrevocable – grantor can’t change, so outside
       estate tax system
      Grantor trust – treated for income tax
       purposes as if owned by grantor
      Dichotomy caused by estate and income tax
       statutes not harmonized


17
          Sale to Irrevocable
            Grantor Trust
  Sale disregarded for income tax purposes
   but respected for transfer tax purposes
  Grantor pays income tax on trust’s income
  Grantor can turn off grantor trust status




18
      Funding Trust

               Grantor


                      Initial gift (1/9?)


              Irrevocable
             Grantor Trust
                  (IGT)

     Note: Annual exclusion gift
     if obtain private letter ruling
19
                  Sale

                   Grantor


     Promissory Note     Equity in S Corp.
                            or p’ship

                 Irrevocable
                Grantor Trust


             Note: No tax on sale
              (Rev. Rule 85-13)
20
     Note Repayment
        S Corp. or P’ship

         K-1             cash

               IGT
      (TIN = grantor’s SSN)

         K-1             note repayments

               Grantor

                          tax payments

                IRS
21
            Sale to Irrevocable
              Grantor Trust
      Note – interest only plus optional
       prepayment
      Ideal – distribute most of business’
       income
      OK – IGT uses tax distributions to
       repay interest and some principal
      Works even if business does not grow

22
           Sale to Irrevocable
             Grantor Trust
      Valuation risk – gift tax
      Valuation risk – estate tax inclusion
      Defined value clause – either variable
      consideration or trustee creates
      separate share for gift element



23
     Grantor Retained Annuity Trust
                (GRAT)

                           Grantor


                initial gift          annuity payments


                               GRAT




          Note: A GRAT is also a grantor trust
24
      GRAT – Structuring Annuity
             Payments
      Defined as percentage of initial value
      Nominal initial gift – practically audit
       proof
      Payments increase by 20% each year




25
         GRAT – Making Annuity
              Payments
      If long-term GRAT, use operating cash
       flow
      If short-term GRAT, use equity interests
       or loan from third party
      If use equity interests, no income tax
       issue but significant valuation issues
       (appraisal every year; bad
       consequences if miss the mark)
26
         GRAT vs. Sale to IGT
  GRAT – safer for gift tax
  GRAT – estate inclusion if die during term
  IGT – more flexible
  IGT – better for multi-generational
     planning




27
           Discount Planning
  Lack of marketability
  Lack of control
  Use non-voting equity interests
  Recapitalization often required (19 for 1)




28
           Discount Planning
  Simple for gifting but beware appraiser
   penalties
  Audit risks more pronounced for sales
  Estate tax risks – tax apportionment
                           discussed later
                    – marital deduction
                      discussed now


29
     Discount Planning – Marital
          Deduction Issues
       Control premium
       Voting equity to marital trust
       Spouse withdraws voting equity




30
      Discount Planning – Voting
           Equity Example
                    Marital        25%     Surviving
                    Trust          Over     Spouse
            70%
                                   time
     Decedent

            30%
                  Credit Shelter
                      Trust

        Ending:   Credit Shelter          30%
                  Marital Trust           45%
31                Surviving Spouse        25%
     Discount Planning – Marital
          Deduction Issue
  Marital deduction includes control
   premium
  Marital trust not aggregated with surviving
   spouse’s own property
  Valuation discount for surviving spouse
   even though actual control as trustee of
   various trusts

32
     Protecting Grantor’s Cash Flow
        Partnership freeze
          Preferred profits interest
          Code § 2701 very complicated




33
     Protecting Grantor’s Cash Flow
  Deferred compensation
       Qualified plans
          Defined benefit
          Defined contribution
          Employee stock ownership plan (ESOP)
       Nonqualified plans (Code § 409A)




34
     Protecting Grantor’s Cash Flow
  Code § 409A
       Violation – income, interest, 20% penalties
       Cannot accelerate payment
       Defer payment – 12 months + 5 years




35
     Protecting Grantor’s Cash Flow
  Qualifying events
         Fixed date
         Separation from service
         Disability (narrow)
         Death
         Change in control (narrow)




36
     Protecting Grantor’s Cash Flow
  Fixed date
  Informally reduce or defer compensation
     or work past fixed date (example next
     slide)




37
     Protecting Grantor’s Cash Flow
  Example: Payments 2021-2030
       2020 wants to continue working in 2021
       2020, agree that part or all of compensation
        earned in 2021 will be paid in 2031
       Net effect – defer retirement by one year
       No deferral of original payment stream




38
     Protecting Grantor’s Cash Flow
  If earn over time to ensure “reasonable”
     compensation, can protect against failing
     to serve –
       Grantor retains voting stock, so can avoid
        termination by employer without cause
       Provide death benefit
       Provide disability benefit
          Consider bonus to provide disability insurance
           instead

39
        Trusts as S Corporation
             Shareholders
  Grantor trust (one grantor)
      Grantor as owner
      Beneficiary as owner (includes QSST)
  Electing small business trust (ESBT)
  Revocable trust after death (and other
     exceptions)


40
       Trust as S Corporation
           Shareholders
      Marital trusts are QSSTs
      Dynasty trusts are often ESBTs
      Can construct trust with primary
      beneficiary treated as the owner




41
     Fiduciary Duties – Investment
  Diversify unless special circumstances
  Trust could explicitly state the special
   circumstances
  Prohibiting a sale is troublesome




42
       Fiduciary Duties – Investment
  Regarding Undiversified Holdings
     Consider:
      Investment Direction Agreements
      Indemnifications
      Directed Trusts
  Document factors leading to determination
     not to diversify


43
     Fiduciary Duties – Loyalty
  Keep control to provide employment to
   beneficiary?
  Trustee’s duty to beneficiary vs. duty to
   other owners of the business




44
            Administering Trust
 Income issues if mandatory income provisions
   and nongrantor trust
      Trust might need to keep distribution to pay
       income tax
      Disappoint beneficiary if trustee, as manager of
       the business, does not have authority or
       inclination to make distributions



45
             Administering Trust
     Issues if QSST or other 678 Trust
       Beneficiary taxed whether or not receives
        distribution
       Trustee might consider utilizing power to
        adjust
       QSST + surviving spouse second marriage –
        need tax account cut-off in shareholder
        agreement


46
 Buy-Sell Agreement – Overview
       Estate tax
       Income tax
       Securing the buy-sell




47
     Buy-Sell Agreement - Overview

          Valuation formula
          Estate tax apportionment
          Marital deduction problems




48
           Buy-Sell – Valuation
      Control adjustment – insider’s
       compensation
      Control adjustment – distribution policy
      Marketability adjustment
      Fair value vs. fair market value



49
              Buy-Sell –
      Fixing Estate Tax Value?
  Must bind during life and after death
  Controlling owner might have rights that
   make non-binding – Blount
  Family business – Code § 2703
   comparability



50
              Buy-Sell –
      Fixing Estate Tax Value?
  Need initial appraisal to prove
   comparability
  Need periodic appraisal to prove updated
   to keep accurate value
  Owners update annually between
   appraisals


51
              Buy-Sell –
       Marital Deduction Issue
  If IRS determines fixed value was too low,
   bargain sale to a person other than
   spouse
  Off by $1 can disallow huge marital
   deduction
  Bequeath business interest to separate
   trust or outright if use fixed formula
  Consider using appraised value instead
52
       Buy-Sell Appraised Value
      Mechanism for selecting appraiser
      Dispute resolution mechanism




53
             Buy-Sell –
     Estate Tax Apportionment
 Who pays estate tax on bargain sale?
 Often, residue of estate/revocable trust
   pays if estate planner takes simple
   approach
  Buyer shall pay the estate tax in many
   situations
  If contract says so, red flag for IRS?
  Be subtle in contract and make sure estate
54
   plan provides equitable apportionment
              Redemption
  Redemption often simplest
  Life insurance estate tax issues (Blount)
  Like insurance income tax issues (S Corp.
   accrual)
  Solvency issues – entity



55
           Cross Purchase
  More complicated
  Fewer tax complications
  Solvency issues – owners




56
          Life Insurance LLC
          (PLR 2007 47002)
  Corporate trustee serves as manager
  Separate set of capital accounts for each
   policy
  Separate capital account for operating
   expenses
  Works for term – need split-dollar for cash
   value component


57
                  LLC (corporate manager)

  policy on B, C +    policy on A, C +       policy on A, B +
 operating account   operating account      operating account


              A              B                 C




58
     Life Insurance – Code § 101(j)
  Death benefit subject to income tax if not
   comply
  Written consent in buy-sell agreement
  Written consent for each policy’s
   maximum stated amount (guess high!)
  Annual reporting


59
            Paying Estate Tax

      Buy-sell proceeds
      Irrevocable life insurance trust buys
       business interest from revocable trust,
       which pays estate tax
      Estate tax deferral (next slide)



60
            Estate Tax Deferral
  Code § 6161 – annual renewal, harder
   each time (interest deductible for estate
   tax purposes only)
  Code § 6166
      4 years interest only
      10 years interest plus 1/10 principal
      Interest at 45% of IRS rate (part is lower)


61
         Estate Tax Deferral –
             Code § 6166
      Automatic lien 10 years
      Special lien extends, replaces (to a
       limited extent)
      Effect on practical credit issues




62
             Profit Interests
  Incentive
  Income tax
  Estate tax
  Alternatives




63
     Profits Interest – Incentive
  Only after consider incentives for short-
   term specific targets within employee’s
   control
  Goal of incentive compensation is to
   maximize profits, so giving a piece of
   future profits aligns employee with
   maximizing future profits


64
     Profits Interest – Income Tax
  No income tax on grant
  Exempt from Code § 409A, so tremendous
   flexibility regarding timing and conditions
   for payment
  Capital gain on sale by employee



65
     Profits Interest – Estate Tax
             (Code § 2701)
  If family business, deemed transfer of
   possibly significantly more than just the
   profits interest
  If family business, every future transaction
   involving any family member becomes
   much more complicated


66
            Profits Interest –
          Code § 2701 Example

                   Before                   After
                        Capital                Capital
         Profits        Account   Profits      Account
 Mom     50%             50       45%           50
 Dad     50%                50    45%               50
 Child   0%                  0    10%                0



67
           Performance Bonus
  If not a partner, no Code § 2701 issues
  Code § 409A applies
  Bonus can be expressed in terms of profits
     or any other relevant measure




68
      Performance Bonus – First
       Example (Code § 409A)
  Based on 2008 performance
  Financial statement done in 2009
  Bonus payable March 15, 2009
  OK if paid later in 2009 (query – effect of
     frequent breach?)



69
        Performance Bonus –
          Second Example
  Based on 2008 performance
  Must be employed first business day in
   2009
  Bonus payable March 15, 2010 or such
   earlier date as is hard-coded into the
   agreement


70
      Creative GRAT Structure
  Parent transfers equity to trust in
   exchange for annuity
  Parent gets more returned if performance
   targets are not attained
  Does not maximize opportunities to
   transfer equity to child, but does provide
   incentive without Code § 2701
   complications

71
               Conclusion
  Fairness issues require separation of
   insiders from outsiders under a long-term
   plan
  Estate tax issues require additional
   planning
  Trusts provide significant benefits but
   require thought regarding cash flow,
   income taxes, and fiduciary duties

72
               Conclusion
  Buy-sell agreements help ensure smooth
   transition
  Life insurance can help fund purchase but
   requires extra attention for income tax and
   estate tax issues
  Need mechanism to ensure actual
   payment of contractual purchase price


73
               Conclusion
  Nonqualified retirement payments and
   deferred incentive payments need to work
   around Code § 409A
  Profits interests are great for income tax
   purposes but can greatly complicate
   transfer tax issues in a family business
  Performance bonuses and creative GRAT
   structures can incentivize children

74

				
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